Is the Insurance Industry Systemically Risky?

Is the Insurance Industry Systemically Risky? Viral V Acharya and Matthew Richardson1 1 Authors are at New York University Stern School of Business. E-mail: [email protected], [email protected]. Some of this essay is based on “Systemic Risk and the Regulation of Insurance Companies”, by Viral V Acharya, John Biggs, Hanh Le, Matthew Richardson and Stephen Ryan, published as Chapter 9 in Regulating Wall Street: The Dodd-Frank Act and the Architecture of Global Finance, edited by Viral V Acharya, Thomas Cooley, Matthew Richardson and Ingo Walter, John Wiley & Sons, November 2010. [Type text] Is the Insurance Industry Systemically Risky? i VIRAL V ACHARYA AND MATTHEW RICHARDSON I. Introduction As a result of the financial crisis, the Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act and it was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act did not create a new direct regulator of insurance but did impose on non-bank holding companies, possibly insurance entities, a major new and unknown form of regulation for those deemed “Systemically Important Financial Institutions” (SIFI) (sometimes denoted “Too Big To Fail” (TBTF)) or, presumably any entity which regulators believe represents a “contingent liability” for the federal government, in the event of severe stress or failure. In light of the financial crisis, and the somewhat benign changes to insurance regulation contained in the Dodd-Frank Act (regulation of SIFIs aside), how should a modern insurance regulatory structure be designed to deal with systemic risk? The economic theory of regulation is very clear. Regulate where there is a market failure. It is apparent that a major market failure in the financial crisis of 2007-2009 was the emergence of systemic risk. More concretely, systemic risk emerged when aggregate capitalization of the financial sector became low. The intuition for why this is a problem is straightforward. When a financial firm’s capital is low, it is difficult for that firm to perform financial services; and when capital is low in the aggregate, it is not possible for other financial firms to step into the breach. This breakdown in financial intermediation is the reason severe consequences occurred in the broader economy. When financial firms therefore ran aground during the crisis period, they contributed to the aggregate shortfall, leading to consequences beyond the firm itself. The firm has no incentive to manage the systemic risk and the negative externality associated with such risks implies that private markets cannot efficiently solve the problem, so government intervention is required. In other words, regulators now need to focus not just on the own losses of a financial institution, but also on the cost that their failure would impose on the system. The question is whether this applies to the insurance sector. Some academics and others have argued with good reason that there are fundamental differences between the insurance and banking sectors (e.g., see Cummins and Weiss (2013), Harrington (2009, 2010, 2013) and Tyler and Hoenig (2009)).ii The argument basically rests on the fact that “traditional” insurers do not [Type text] write and retain large and concentrated amounts of nontraditional insurance or similar risk management products with exposure to macroeconomic variables. That is, traditional insurance usually protects policyholders against risks that they deem significant but that are at least reasonably idiosyncratic and thus diversifiable from the insurers’ perspective.iii Moreover, insurance companies have much longer-term and less liquid liabilities which make them less susceptible to runs on their liabilities of the sort that plague financial firms during typical financial crises. It does not follow, however, that systemic risk cannot emerge in what is typically defined as the insurance sector. One of the main reasons is that researchers misunderstand the meaning of systemic risk. As describe above, the emergence of systemic risk is that financial firms will no longer be able to provide intermediation, causing knock-on effects to households and businesses. The purpose of this chapter is to explain why the insurance sector may be a source for systemic risk. In brief, we argue that the insurance industry is no longer traditional in the above sense and instead (i) offers products with non-diversifiable risk, (ii) is more prone to “runs”, (iii) insures against macro-wide events and (iv) has expanded its role in financial markets. This can lead to the insurance sector performing particularly poorly in systemic states, that is, when other parts of the financial sector are struggling. We provide evidence using publicly available data on equities and credit default swaps. As an important source for products to the economy (i.e., insurance) and a source for financing (i.e., corporate bonds and commercial mortgages), disintermediation of the insurance sector can have dire consequences. Indeed, the recent decision by the Financial Stability Oversight Council (FSOC) to name AIG and Prudential (and potentially MetLife) as SIFIs was related to this point. The chapter is organized as follows. Section II describes the arguments for and against systemic risk regulation of the insurance sector. Given the Dodd-Frank Act’s required regulation of insurance companies that are designated SIFIs, there is perhaps no greater controversy in insurance regulation. In section III, we provide an empirical analysis of the systemic risk of insurance companies based on a specific systemic risk measure. While sections II and III address specific issues related to systemic risk, in section IV, we analyze this question with respect to regulation at the federal versus state level. II. Are Insurance Companies Systemically Risky? Our argument is that systemic risk emerges when aggregate capitalization of the financial sector is low. In the recent crisis, full-blown systemic risk emerged only when, in the early Fall of 08, the GSEs, Lehman, AIG, Merrill Lynch, Washington Mutual, Wachovia, and Citigroup, among others, effectively failed. The result – as we have seen painfully in several crises over past forty years around the world - was loss of intermediation to households and corporations. It is this breakdown in financial intermediation that severe consequences occurred in the broader economy. For insurance companies, disintermediation can take several forms. For example, the willingness of insurance companies to supply insurance products may suffer, leading to higher prices and an overall loss of economic welfare. There is growing evidence that capital constrained financial firms, including insurance companies, may reduce the supply of capital in the face of losses. For [Type text] example, in the catastrophe insurance area, Froot (2001) and Froot and O’Connell (1999) find that insurance premiums not only appear high relative to expected losses in these markets, but increase dramatically after a catastrophe.iv Interestingly, this increase spills-over to insurance markets not affected by the catastrophe. Garmaise and Moskowitz (2009) find that the supply of credit for catastrophe susceptible properties in California fell after the earthquakes in the 1990s.v It is an open question whether these supply shocks extend beyond the catastrophe insurance area. In addition, as an important player in the financing of credit-linked activities, insurance companies are an essential part of the economic system. Almost all financial firms have in common the characteristic that they are holders of long-term assets. Through the flow of funds within the economic system, these firms provide financing to real economy firms. These firms are in effect all financial intermediaries, such as banks holding retail, commercial and mortgage loans, insurance companies holding corporate bonds, money market funds buying commercial paper, mutual funds and hedge funds holding equity and other securities, structured investment vehicles pooling loans into asset-backed securities, and so forth. In addition, some financial firms provide additional functions to real economy participants such as payment and clearing, liquidity, insurance against catastrophic risks, etc… The important point is that all firms are potentially important. As we make clear below, the key factor in their systemic risk determination is whether the firm contributes to the aggregate capital shortfall. Life insurance companies are one of the largest investors in the U.S. capital markets and therefore an important source of funding for the U.S. economy. (See, for example, in this volume, Cummins and Weiss (2013) and Paulson et. Al. ). For example, the American Council of Life Insurers (ACLI) estimates that, at the end of 2010, life insurers held almost $5 trillion in total assets, with them being the largest single investor in U.S. corporate bonds (17%) and a significant player in the commercial mortgage market (9.5%). If these firms are in distress and can no longer play their role as financiers for corporate America, then this is precisely the concern about systemic risk. In particular, if AA- and AAA-rated firms find it punitively expensive to issue corporate bonds, then they would draw down on their bank lines of credit as a form of last-resort financing, triggering massive liabilities for their relationship banks. While the healthier banks with adequate capital and deposit base might be able to meet the sudden drawdowns of credit lines, moderately risky banks could experience

Load more